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The Oil Market in the Age of Shale Oil

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The Oil Market in the Age of Shale Oil Articles 1 The oil market in the age of shale oil Prepared by Irma Alonso Álvarez and Virginia Di Nino US shale oil production has expanded greatly since 2011, and now rivals that of Russia and Saudi Arabia in terms of market share. However, major producers of conventional oil, and members of the Organization of Petroleum Exporting Countries (OPEC) in particular, have been slow to adapt their production policies. This article investigates the reasons for this delayed reaction and provides an assessment of the relative importance of supply and demand factors in driving oil price developments in the wake of the shale oil “revolution”. Shale oil is the key novel factor affecting the structure of the oil market and influencing OPEC’s decisions whether to target price stabilisation or market share. The prolonged period of oversupply and low oil prices between the end of 2014 and the third quarter of 2016 was a result of the interplay of these factors; the partial recovery in prices, which occurred in 2017, reflects a gradual rebalancing of the market following the global supply restraint agreed by OPEC and major non-OPEC producers. Analysts expect oil prices to remain in a range consistent with the production costs of the major marginal producers – currently assessed to be around USD 50 per barrel over the short term. However, according to their projections, and given current extraction technology, prices must rise to around USD 65-70 per barrel over the medium term if shale oil production is to continue expanding profitably at a robust pace. 1 Introduction Commodities, and oil in particular, remain the most important source of volatility in consumer price inflation. This poses a challenge for projections, as oil prices account for most of the prediction errors in inflation rates. Understanding the drivers of oil price movements is fundamental to an assessment of their persistence and of the implications for inflation expectations, as well as, ultimately, to the ability to tailor the monetary policy response. The surge in shale oil production since 2011 is generally considered to have created a structural transformation of the oil market, however several questions remain open: to what extent has that transformation so far affected the supply and demand factors which drive the oil price; and what is its relevance over the longer term? The shale oil revolution has attracted significant interest because it marks a historical and unexpected turning point in US energy production trends. After three decades of steady decline, US oil production provided the largest contribution to global supply growth in the period from 2012 to 2014, and today rivals that of Saudi Arabia and Russia in terms of its share of global oil production. Initially, shale oil was essentially a US phenomenon, as both technical and legislative issues limited its global impact. In particular, the oil streams in the US, Canadian and Mexican ECB Economic Bulletin, Issue 8 / 2017 – Articles The oil market in the age of shale oil 57 pipeline systems were only able to absorb flows from the periphery into the internal US states, and exports of US crude oil were banned by a law which had been introduced for national security reasons. Both of these factors led to an extraordinary build-up of inventory, depressing oil prices within the United States. Quality differentials for delivery in landlocked stocking points, such as the West Texas Intermediate (WTI) benchmark32 (the main benchmark used in the United States) were priced at an increasing discount. Prices for energy products became cheaper in the United States than in the rest of the world. However, the subsequent inversion of the oil streams in the pipelines and the creation of additional rail capacity in 2014, combined with the repeal of the export ban a year later, served to close the gap between US and international oil prices and bring US shale oil into the global arena. By this point, the US Energy Information Administration (US EIA) had made several positive reassessments of shale oil, in terms of both future quantities and life span, suggesting that permanent changes were occurring in the global oil market. OPEC’s production decisions during the shale oil age – which began around 2011 – have been particularly influenced by the evolving supply conditions in the United States. In November 2014 production targets were abandoned in an attempt to regain market share; this aim was achieved, but at the cost of a drop in oil prices of more than half. Persistently low prices and producer nations’ impaired public finances prompted OPEC’s decision in November 2016 to change its policy again and restrain production, in an effort to rebalance the oil market which had been swamped with inventory. Had OPEC accepted the fact that in its role as swing supplier it was now competing with shale oil producers? This article describes the evolution of the oil market during the shale oil age, the shifts in OPEC’s production strategies and the effects of both of these developments on oil prices. It is structured as follows: Sections 2 and 3 review oil price dynamics and market fundamentals both before and during the shale oil age, with a particular focus on the market shares of major oil producing countries (notably the United States) following the revolution set in motion by the shale oil industry. Box 1 provides details of the structural VAR (SVAR) model of the global oil market used to assess the relevance of supply and demand factors, in which two types of strategies are distinguished, depending on whether OPEC acts to protect its market share (the “strategic” approach) or to stabilise oil prices around a target value (the “accommodative” approach). Box 2 discusses the historical decomposition of the oil price, focusing on the period of shale oil production. Section 4 assesses the potential implications of shale oil for the global supply curve and the equilibrium price, based on micro-level evidence. Section 5 summarises the main themes of the article and concludes with perspectives over the medium and the long term. 32 The delivery point under the WTI contract is Cushing in Oklahoma. ECB Economic Bulletin, Issue 8 / 2017 – Articles The oil market in the age of shale oil 58 2 A narrative of pre-shale oil price dynamics Developments in the oil price in the years preceding the global financial crisis sowed the seeds for the shale oil revolution. The steep rise in price from USD 23 per barrel in 2003 to an all-time high of USD 145 per barrel on the eve of the global financial crisis was primarily a reflection of surging demand in major emerging economies such as China (see Charts 1 and 4). On the supply side, while non- OPEC producers were struggling to keep up with expanding consumption, OPEC’s preference – according to the empirical analysis – was to maintain a relatively tight market and exploit its renewed power to influence market equilibrium (see Chart 3). Chart 1 Brent and WTI crude spot prices since 2000 (USD per barrel) Brent crude spot price WTI crude spot price 150 130 110 90 70 50 30 10 2000 2002 2004 2006 2008 2010 2012 2014 2016 Sources: Bloomberg, Datastream and ECB staff calculations. Note: The latest observations are for 19 October 2017. Chart 2 Changes in the price differential between Brent crude and WTI since 2000 (USD per barrel) 40 30 20 10 0 -10 -20 2000 2002 2004 2006 2008 2010 2012 2014 2016 Sources: Bloomberg, Datastream and ECB staff calculations. Note: The chart plots the difference (spread) between Brent crude and WTI prices. The latest observations are for 19 October 2017. ECB Economic Bulletin, Issue 8 / 2017 – Articles The oil market in the age of shale oil 59 Against this background, capital flowed to the shale oil industry to finance investments in research and development. Medium-sized energy companies, generally more financially constrained than the multinationals, took advantage of these capital inflows to further develop horizontal drilling and hydraulic fracturing techniques in the United States, making shale oil production viable and profitable. The development of shale oil production also benefited from the fact that resources were located in sparsely populated areas, and that in the United States land ownership rights include rights to sub-surface minerals and environmental regulation is less strict than in, for example, Europe.33 The extraction of oil and natural gas from shale rock formations has had a lasting effect on the US energy mix and markedly reduced the United States’ dependency on external energy; this has, in turn, helped reduce the perennial US trade deficit. Over the same period (2003-2007), OPEC regained influence on the oil market by addressing increasing demand from fast-developing emerging economies and stepping in to compensate for significant and protracted disruptions in production. In particular, new lows in prices in the aftermath of the Asian financial crisis of 1997 had restrained field investments for years, and conventional production, which lacked spare capacity, was unable to expand and respond to the growing demand from China and other emerging economies. The gap between global demand and supply was exacerbated by two major disruptions: a drop of 60% in Venezuelan oil production34 caused by a protracted strike which took place at the national oil company, Petróleos de Venezuela, in late 2002 in an attempt to force the then-president to call early elections; and the Second Gulf War in 2003. Given the general market conditions, OPEC was able to maintain a relatively tight market balance in order to support high oil prices during this period prior to the global financial crisis (see Box 1).
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